Lessons of a Trader
We had a position not in the spread between the two stocks, but between their options: the options of FDC were much cheaper than those of CE. Once the deal closed, these options would merge. Our firm does not play direct risks, like the "risk arb spread", but derivative, secondary risks, like the volatility between the two.
So we lost money yesterday when the DOJ announced their opposition to the merger (at least for right now): even though we were not "long" the spread, the resulting impact to the options was negative. Even though a position in the options is a higher probability (return for risk) bet than directly buying the spread itself, which is what we look for, it is not without risk. When we factored in the risks, such as the possibility of the spread widening, it becomes a matter of valuing and trading the options separately.
The point of this is not to explain the details of our trade; it is to illustrate sizing a trade. From the outset of the trade we create various assumptions, conservatively estimating what can go wrong and what it will cost us if it does. Given our assumptions, the expected value (adding together the returns of each scenario multiplied by the probability of each of those scenarios) was very positive. We felt we could make three times what we could lose if our assumptions proved correct.
They weren't. The ugly scenario has played out, at least for now. So now we manage the position conservatively, assigning a somewhat higher probability than before that the deal will not close eventually, which leads us to value the options of each company separately. Our objective now is not to try to make all our money back, but to minimize the loss. In the worst case we estimate that we can lose .75% of our assets (from the outset of the trade) with a reasonable probability of breaking even, even if the deal does not go through.
A trader must take losses to make gains, but it is crucial to always have a favorable risk reward, never bet too much on one position, and manage the losing trades to minimize losses.
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